The Many Faces of Microfinance
Authored by Jason Kaye
As the microfinance industry grows on both a domestic and an international scale, the forms and functions of microfinance institutions (MFIs) worldwide are evolving. There is a growing effort on the part of MFIs and academics to specifically define microfinance. As MFIs adapt to better address the diverse financial needs of the global unbanked, this becomes increasingly difficult. It is clear that microfinance – simply a term for small-scale financial services generally provided for low-income individuals – comes in many shapes and sizes.
Microfinance attempts to address a number of problems associated with providing the poor with financial services. If providing financial services to the poor were simple and intuitive, large financial institutions would already be doing so. Luckily, in the United States, the poor have access to a variety of financial services; the availability of savings and credit is widespread. However, certain unique needs of low-income individuals render the application of traditional financial services inappropriate – they often do more harm than good – and the services to which the poor have access are highly limited. In the case of the international poor, these services are largely nonexistent.
Challenges in Banking for the Poor
Why is it so difficult to offer financial services to the poor? One of the most important challenges is a lack of efficient and comprehensive risk-assessment methodology. Large financial institutions often assume that lending to the poor would involve an unmanageably high default rate. While MFIs worldwide have boasted shockingly low default rates, a different sort of banking must be provided in order to ensure this. Lenders must be flexible with clients, and expend a great deal of resources guiding their clients through the lending process. Financial literacy education is essential to microfinance, as borrowers will often have no background in dealing with financial services. Borrowers may have poor or nonexistent credit histories and no collateral to offer.
On the international scene, remoteness of clients and high transaction costs are a second major problem. Carrying money from central bank locations to remote villages is expensive. Though the spread of technology is helping to diminish this challenge, the obstacle of distance can still make or break a rising MFI.
Addressing the Challenges
Though these sorts of challenges vary from region to region, MFIs have developed a number of adaptable ways to deal with them. Risk minimization can be combated through financial education, highly personalized lender-client relationships, the creation of non-material collateral, and borrower aggregation leading to portfolio diversification. Remoteness of clients is more difficult to address, but technology, multiple small branch locations, and borrower aggregation provide the first steps.
A Sampling of Models
One of the simpler models, often used in domestic microfinance, is the individual borrower model. Loans are distributed to individual borrowers, and risk minimization is carried out through strong relationships between borrowers and loan officers. Financial education often precedes loan disbursement, and coordination between lender and borrower is extensive. This model does not specifically address the issue of widespread inter-region outreach, and is generally used on a smaller scale within a single city or region.
The Grameen Model was a revolutionary step in microfinance, combining a few different concepts in order to address the needs of borrowers. Five potential borrowers are grouped together, and the first two borrowers receive loans. Only when those borrowers repay their loans do the next borrowers receive their own loans. This model minimizes risk by creating a system of “peer pressure” collateral, causing borrowers to ensure each other’s loans. It begins to address the issue of outreach by aggregating borrowers, thereby simplifying the lending process.
The Indian Self-Help Group (SHG)-Bank Linkage Model is a new and growing form of microfinance in India that represents a complex partnership between government, non-governmental organizations (NGOs), large-scale financial institutions, and villages. It provides us insight into some of the more complex and macro-level microfinance models. Democratically-governed village SHGs consisting of 10-20 members begin taking small deposits from each member. The SHG uses this money to open a bank account with a large financial institution – often a commercial bank – and the government or an NGO helps to facilitate the process and educate members of the SHG. The SHG begins to lend its small pool of money among members to help them become familiar with the process of receiving and repaying loans. Eventually, the SHG receives a loan from the bank, and distributes the loan among its members as it sees fit. Repayments are collected by the SHG and passed on to the bank. This model minimizes risk by administering single loans to a diverse portfolio of borrowers, and by allowing the SHG in aggregate to ensure repayment, along the lines of the “peer pressure” model. It encourages financial literacy by involving socially-motivated forces such as the government and NGOs, and its outreach is growing rapidly because of the profits that large-scale financial institutions stand to gain by tapping into rural poor markets.
This summary provides only a glimpse of the different types of microfinance that exist, and the industry is growing and developing every day.
The Capital Good Fund Model
Capital Good Fund’s unique mission and foundation is reflected in its model. Its volunteer base and centralization allows it to carry out risk-minimization through highly personalized service, including financial literacy education. Located in Providence, RI, we serve a centralized client base, and thereby avoid high transaction costs. This individual borrower model is well-adapted to the Providence’s needs, and allows us to provide appropriate service to our clients.
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